Ed Miliband is facing the biggest crisis of his three-year Labour leadership after the party's largest union backer, Len McCluskey, accused the party's leadership of a "stitch-up" and a "scandalous" attempt to smear his Unite union over the bitterly contested selection for the Falkirk parliamentary seat.

The growing row also claimed its first high-profile victim when Labour's election co-ordinator, Tom Watson, resigned from his post and the shadow cabinet, saying he wanted to preserve party unity and claiming he no longer wanted to be on the political merry-go-round.

Hours after his resignation, Watson's office manager, Karie Murphy, was suspended from all offices in the party, along with the Falkirk party chairman, Stephen Deans. Murphy, a close ally of McCluskey, had been trying to win the Labour nomination in Falkirk.

The bitter dispute stems from the selection race to replace the MP Eric Joyce, who resigned from the party after admitting assault in a Commons bar brawl. It is alleged Unite tried to "stitch up" the selection process by cramming the constituency with new members.

Watson, a former Unite official, has been accused of helping the union orchestrate a string of parliamentary selections designed to secure seats for Unite members, or its union allies.

With the Conservatives on the offensive over Labour's relationship with Britain's biggest union, Miliband now faces a choice between trying to cool the potentially crippling dispute with his biggest financial backer, or instead view the crisis as the opportunity to show leadership and call for a broad recasting of the party-union relationship.

Labour officials exonerated Watson from any wrongdoing in Falkirk or elsewhere, but claimed McCluskey, as Unite general secretary, "has to take some responsibility for what he has done. The action of Unite in Falkirk has caused us problems". The officials added: "We are not going to be pushed around."

A furious McCluskey responded in inflammatory language, denouncing the party's own investigation as a stitch-up designed to "produce some evidence, however threadbare, to justify predetermined decisions". He added that he had lost faith in Labour headquarters and said he would be demanding the party set up an independent inquiry into the disputed Falkirk selection. He will have the first chance to make that demand at a meeting of the party's national organisation sub-committee on Tuesday, but the decision to endorse the Falkirk investigation and suspend the two party members in the Scottish constituency has already been agreed by senior party officials, at a meeting yesterday.

In a letter to the party general secretary Iain McNicol, McCluskey said: "The report has been used to smear Unite and its members. Even if the allegations of people being signed up to the party without their knowledge were true, this had nothing whatsoever to do with my union … The mishandling of this investigation has been a disgrace. I, however, am obliged to uphold the integrity of Unite, and I can no longer do so on the basis of going along with the activities of a Labour party administration in which I can place no trust."

Labour took a first step to refashion the relationship by ending the general scheme under which unions could sign up members to the Labour party and pay the fees on their behalf. About 400 union members had joined the party under the scheme. The party had already taken national control of the Falkirk selection and debarred suspects recruits from taking part in the eventual ballot.

The Unite leadership had described the way in which it had recruited members in Falkirk as exemplary. It has also targeted 41 other constituency parliamentary contests in a bid to secure the nomination for a Unite backed candidate.

In his resignation letter – his third from the Labour front bench – Watson disclosed that he believed the party report into Falkirk should be published, something the party has rejected on the grounds evidence had been given in private. He also revealed he had tried to resign on Tuesday, but had been dissuaded by Miliband.

Writing in his idiosyncratic style, Watson states: "It's not the unattributed shadow cabinet briefings around the mess in Falkirk that has convinced me that the arrangement, as election co-ordinator, has run its course (though they don't help)".

Watson insisted he was not disenchanted with Miliband's leadership: "Having resigned a couple of times before, I know how puckish lobby hacks might choose to misconstrue the departure. So to make it harder for them let me say this: I'm proud of your Buddha-like qualities of patience, deep thought, compassion and resolve. I remain your loyal servant. I'll always be on hand to help you if you need me. I just don't think you need me in the shadow cabinet any more."

Watson ended with a parting thought about the need for politicians to have a hinterland. He recalled that BBC presenter John Humphrys last weekend had asked him at Glastonbury why the Labour leader was not there. "I said Labour leaders can't be seen standing in muddy fields listening to bands. And then I thought how terribly sad that this is true. So: be that great Labour leader that you can be, but try to have a real life too.

"And if you want to see an awesome band, I recommend Drenge," he wrote referring a little known duo who were picked by the Guardian last week as future headliners at Glastonbury.